Cisco Systems: JP Morgan Ups to Hold on Enterprise Rebound

By Tiernan Ray

Shares of Cisco Systems (CSCO) are down 26 cents, or 1%, at $26, after J.P. Morgan's Rod Hall raised his rating on the shares to Neutral from Underweight in advance of the company's fiscalQ4 earnings release next Wednesday, August 14th, writing that trends in the the company's sales to enterprises continue to get better.

Cisco's market is actually a bright spot within overall IT spending, relative to servers and other gear:

Our original downgrade to Underweight was based on a negative earnings view linked to weaker enterprise spending as well as our opinion that SDN risk would cap Cisco’s multiple (our full downgrade report can be found here). As the year has progressed, overall Enterprise IT spending has indeed been weak in our opinion with forecast cuts from IDC and Q2 misses at enterprise heavyweights including Microsoft (MSFT), Oracle (ORCL), Xerox (XRX), Google (GOOG), and IBM (IBM). However, Enterprise Networking exposed companies such as F5, Riverbed, Citrix, Juniper, and Cisco (in May) have all indicated stronger underlying networking spending trends. In addition, data points in the relevant networking supply chain paint a positive demand picture looking forward from here in our opinion. While the macro picture remains uncertain we find it tough to ignore these better than expected trends.

He notes positive indicators from Cisco itself in its prior report:

Cisco reported a turn in total order trends as product orders moved up to 4% Y/Y in FQ3 (to April) from 0% for the two quarters prior to that. Even though the comp from FQ3 last year was weak we believe the company likely saw solid Q/Q order volume growth. Likewise, European order growth was flat in FQ3 after a decline of 6% in FQ2. These changes in order trends combined with strong US enterprise and commercial segment growth suggest that we may finally be reaching the bottom on enterprise related networking spending.

The spending by government is still an issue, but it, too, appears to be getting better, he thinks:

Cisco’s public sector order growth rate improved to 1% Y/Y in FQ3’13 (to April) from no growth in FQ2 and a 6% Y/Y decline in FQ1. US Public sector orders grew 5% Y/Y, driven by strong 13% growth in US State and Local. US Federal orders declined by 3% Y/Y, partially offsetting the strength in US State and Local in FQ3. However, US Federal order growth rate trend has improved from 5% decline in FQ2 and 15% decline in FQ1, indicating slowing pressure in the sector. We believe that US State and Local may be better in H2 as housing driven gains cause some relaxation of spending caution. However, US Federal may see more pressure as debt ceiling and sequestration related debates impact spending post September.

However, Hall is reluctant to go more positive on the stock given he thinks Cisco faces the long-term threat of “software-defined networking” eroding the value of its switches and routers:

This upgrade doesn’t change our view on the impact of SDN for Cisco. We believe that software based control systems are likely to lead to the adoption of “bare metal” Ethernet switching hardware in both data centers and possibly on enterprise campuses. In our opinion this transition leads to a large reduction in the profitability of the Ethernet switching market as well as a near halving of the total revenue size of the market. We see this occurring even as overall demand for switching ports continues to grow.

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.